A Compilation of Enforcement and Non-Enforcement Actions

14 February 2011 Publication
Author(s): Peter D. Fetzer Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

SEC Study Recommends a Uniform Fiduciary Standard for Providing Investment Advisory Services

To no one’s surprise, the SEC — within a report mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act — recommended that regulations be implemented to create a uniform fiduciary standard for all providers of personalized investment advice to retail customers, whether such providers are registered as broker-dealers or investment advisers.

The report has not been endorsed by the SEC members and, at this point, merely reflects the views of the SEC staff. Indeed, it is likely that some of the SEC members will find such regulations unnecessary and possibly, if adopted, would constitute a hindrance rather than an aid in achieving greater investor protection. The study reported on was mandated by Section 913 of Dodd-Frank directing the SEC to study the effectiveness of the current standards applicable to broker-dealers and investment advisers and then make recommendations to address “gaps” in investor protection between the two registered groups. According to the SEC, out of the approximately 12,000 SEC registered investment advisers, approximately five percent also are registered broker-dealers and 22 percent of the 12,000 registrants have a related person registered as a broker-dealer.

The uniform fiduciary duty recommended by the SEC staff would require all brokers, dealers, and investment advisers that provide personalized investment advice about securities to “retail” customers to act in the best interest of the customer without regard to their own interests. The staff stated in its report that the uniform fiduciary standard should not be “less stringent” than the standard for investment advisers under the Investment Advisers Act of 1940. The SEC will need to further define the term “personalized advice” and identify the “retail” customers that will be afforded the fiduciary standard protections.

Considered by the staff, but not recommended in the study, was the repeal of the exclusion from the definition of an investment adviser under the Advisers Act for a broker or dealer providing investment advisory services but the performance of such services is incidental to its business as a broker or dealer and which receives no special compensation for such services. Some critics of the staff’s study state that the SEC failed to make the case that such a standard is necessary for the protection of investors. Instead, such critics state it is conceivable that, if the adopted standard includes brokers and dealers, the net result could mean fewer and more expensive investment choices for retail investors. Interestingly, some within the broker-dealer industry appear to support the staff recommendation citing that the recommendation was a reasonable approach that should have a positive impact for retail customers.

Now that the SEC has concluded its study and reporting as mandated by Dodd-Frank, it will be up to Congress for possible next steps on whether a uniform fiduciary standard should be adopted.

SRO for Investment Advisers Revisited

As a follow-up to the article in our December 2010 Investment Management Update discussing whether an SRO will be created by Congress to help further regulate SEC-registered investment advisers (http://tinyurl.com/6fhhk85), the SEC’s staff offered its views on the subject in a recent report.

The staff report accompanying its study on enhancing the examination of investment advisers (another study mandated by Congress through Dodd-Frank) offered three alternatives to provide the SEC with additional examiners and financing to meet the examination enhancement mandate Dodd-Frank imposed upon the SEC. The first alternative recommended by the staff is to have Congress create one or more SROs to regulate investment advisers under the SEC’s supervision. That alternative would be similar to the regulatory oversight model currently used for SEC registered brokers and dealers under which the Financial Industry Regulatory Authority (FINRA) under the SEC’s supervision regulates brokers and dealers. Some industry groups and the National Association of State Securities Administrators, Inc. (NASAA), the members of which constitute the securities administrators of all 50 states, oppose the idea of a self-regulatory organization taking over direct regulation of investment advisers. The second alternative recommended is for Congress to authorize the SEC to charge registered investment advisers a fee for conducting an examination and to allow the SEC to use those funds to conduct the examination program instead of depositing those fees in the U.S. Treasury. Many of the state securities administrators have the statutory authority to charge fees for examinations they conduct over state registrants. The third alternative recommended by the SEC staff is to authorize FINRA to conduct examinations over their broker-dealer members who also are registered as investment advisers.

It appears clear to almost all that Congress will need to act if the SEC is going to fulfill its mandate to increase the number and quality of examinations of registered investment advisers.

Dodd-Frank authorized Congress to appropriate $1.3 billion for the SEC in fiscal year 2011, a nearly 20-percent increase from the SEC’s 2010 budget to cover its mandates. However, as of this date, Congress has failed to approve such appropriations. Instead, currently what is authorized by Congress is to continue funding all federal agencies at the 2010 levels. Adding to the mix is that some of the congressional critics of Dodd-Frank, instead of seeking to repeal the entire Act, may wish to keep a close hold on the purse strings for such agencies as the SEC and CFTC. SEC Chairwoman Mary Shapiro has publicly stated that the SEC will not be able to meet its mandates without increased funding. Supposedly, the staff has already imposed, due to budget constraints, some reductions on staff travel to conduct examinations of out-of-the-way registered investment advisers and has postponed some other on-site investment adviser examinations previously scheduled.

According to SEC Commissioner Elisse Walter, the SEC would have to add approximately 2,000 examiners to its current examiner force just to equal the rate of broker-dealer examinations currently conducted by FINRA. Although Dodd-Frank requires so-called mid-sized investment advisers (those with assets under management of between $30 million and $100 million to withdraw from registration with SEC and register at the state level), it is expected that with the new requirement under Dodd-Frank for private fund advisers to register with the SEC (to the extent that they have assets under management of $150 million or more), and with the increasing number of investment advisers entering into the industry, the net reduction of SEC registered investment advisers will not be at a sufficient number to take meaningful examination pressure off of the SEC’s shoulders.

Adding to the discussion is the Executive Council of the American Bar Association’s Securities Law Committee that, on January 25, 2011, urged Congress to either significantly increase the SEC’s budget or remove the SEC from the current appropriations process to that of a self-budgeting agency (i.e., the SEC could charge registrants for conducting examinations and could keep those fees for operational costs, which is the staff’s second recommendation described in this article).

The Council, in support of its position, cited that banking agencies use the self-budgeting approach and that has worked well over the years.

It is likely that the issue over funding for the SEC will come to a head in the early part of this congressional session.

Pay-to-Play Policies and Procedures

The date to comply with the SEC’s “pay-to-play” rule, Rule 206(4)-5, is fast approaching. Rule 206(4)-5 applies to all investment advisers registered, or required to be registered, with the SEC, as well as investment advisers currently exempt from federal registration under the private adviser exemption.

Investment advisers subject to rule 206(4)-5 must comply with the rule on March 14, 2011. Investment advisers may no longer use third parties to solicit government business except in compliance with the rule on September 13, 2011. Investment advisers to registered investment companies that are investment options of a plan or program of a government entity must comply with the rule by September 13, 2011.

To ensure compliance with the rule, investment advisers should adopt and implement policies and procedures reasonably designed to prevent violations. The policies and procedures should cover the provisions discussed below, and address remedial actions to be taken if violations occur. At a minimum, remedial action should include taking all reasonably available steps to cause the contributor involved in making the prohibited contribution to obtain a return of the contribution.

In drafting pay-to-play policies and procedures, it is important to understand the primary object of the rule. Namely, the rule is designed to prevent investment advisers from seeking to influence government officials’ awards of advisory contracts by making or soliciting political contributions to those officials (pay-to-play practices). Pay-to-play practices could, for example, lead a political official to choose an investment adviser with higher fees or inferior investment performance because the adviser contributed funds to the official’s election campaign. To combat these pay-to-play practices, the rule does not ban or limit the amount of political contributions an adviser or its covered associates can make, but imposes a limited “time-out” on conducting advisory business for compensation with a government client after a contribution is made.

To combat pay-to-play practices, the rule defines “contributions” broadly to include any gift, subscription, loan, advance, or deposit of money or anything of value made for: (1) the purpose of influencing any election for federal, state, or local office; (2) payment of debt incurred in connection with any such election; or (3) transition or inaugural expenses of the successful candidate for state or local office. The rule also includes a provision that prohibits any indirect action that would be prohibited if the same action was done directly.

With the object of the rule and its broad application in mind, the policies and procedures should set forth an explanation of the applicable limitations and the related procedures to be followed. The following is a brief summary of the restrictions imposed by the rule:

  • Restrictions on the Receipt of Advisory Fees. The rule prohibits the receipt of compensation by an investment adviser from a government entity for the adviser providing investment advisory services for two years following a contribution to any official of that government entity. This prohibition also applies to any contribution made by a covered associate of the investment adviser, subject to a de minimis exception (namely, contributions from natural persons of $150 per election, or $350 per election if the contributor is eligible to vote in the election).
  • Restrictions on Payments for the Solicitation of Clients or Investors. The rule prohibits an investment adviser and any covered associated from providing or agreeing to provide, directly or indirectly, payment to any person to solicit a government entity for investment advisory services on behalf of the adviser unless such person is a regulated person or is an executive officer (or a person with a similar status or function) or employee of the adviser.
  • Restrictions on the Coordination or Solicitation of Contributions. The rule prohibits an investment adviser and any covered associate from coordinating, or soliciting any person or political action committee to make, any: (1) contribution to an official of a government entity to which the adviser is providing or seeking to provide investment advisory services; or (2) payment to a political party of a state or locality where the adviser is providing or seeking to provide investment advisory services to a government entity.

The following are some sample procedures that may be implemented to ensure compliance with the rule and its limitations:

Political Contributions

  • Political contributions by the investment adviser or employees of the adviser to politically connected individuals or entities with the intention of influencing such individuals or entities for business purposes should be prohibited.
  • If an employee or any affiliated entity is considering making a political contribution to any state or local government entity, official, candidate, political party, or political action committee, the potential contributor should be required to seek pre-clearance from the investment adviser’s chief compliance officer.
  • The chief compliance officer should meet with any individuals who are expected to become “covered associates” to discuss their past political contributions.

Charitable Donations

  • Donations by the investment adviser or employees to charities with the intention of influencing such charities to become clients should be prohibited.
  • Employees should be encouraged to notify the chief compliance officer if they perceive an actual or apparent conflict of interest in connection with any charitable contribution.

Public Office

  • Employees should be required to obtain written pre-approval from the chief compliance officer prior to running for any public office.
  • Employees should not be allowed to hold a public office if it presents any actual or apparent conflict of interest with the investment adviser’s business activities.

Enforcement Matters

Fund Portfolio Manager Sanctioned for Charging Undisclosed Fees

In an SEC administration proceeding (In the Matter of Thomas S. Albright, SEC Release No. 34-63676), the SEC issued a cease-and-desist order and imposed a bar upon a portfolio manager of a registered investment adviser from association with, among others, brokers, dealers, investment advisers, municipal securities dealers, or advisers, with the right to reapply for association after one year. According to the SEC, the portfolio manager, while co-managing a fund operated and managed by his employer, an investment adviser, engaged in deceptive conduct and a breach of fiduciary duty by charging additional “credit monitoring fees” to bond issuers for functions that were part of the manager’s regular responsibilities as manager of the fund. Apparently, the investment adviser was not aware of the fees charged by the portfolio manager. The matter came to the attention of the investment adviser when the portfolio manager reported the source of outside income to his employer/investment adviser.

The SEC charged that while conducting such activities, the portfolio manager violated provisions of both the Investment Company Act of 1940 and the Investment Advisers Act of 1940 (primarily under the “anti-fraud” provisions under the Advisers Act). The manager also was ordered to pay disgorgement, interest, and a civil penalty (in total, more than $300,000).

Investment Firms and Executives Charged With Fraud and Misuse of Client Assets

The SEC recently charged three affiliated investment firms and some of their senior executives with violations of the Investment Advisers Act of 1940, including fraud and misuse of client assets (SEC v. Landberg, S.D.N.Y., No. 11 CV 0404, 1/20/11).

According to the SEC’s complaint, West End Financial Advisors, LLC, West End Capital Management LLC, and Sentinel Investment Management Corp., all affiliated entities located in New York City, and their executive officers, William Landberg and Kevin Kramer, misled investors about their investments being safe. In fact, according to the SEC, the investor’s funds were in jeopardy due to financial problems due to Mr. Landberg’s “failed investment strategies.” Among other things, according to the SEC charges, the investment advisers misappropriated and commingled client assets while maintaining that they had a successful operation. According to the SEC, the defendants used client assets to fraudulently obtain a bank loan and used millions of dollars of client assets for personal benefit.

According to the SEC, Mr. Landberg concealed the dire financial condition of his firm by, in part, using client assets in an attempt to prop up his firm and pay off other clients who demanded a return of their assets. Mr. Landberg also is facing a criminal securities fraud complaint in the same New York district court over his activities at West End.

According to the SEC, Kevin Kramer, one of the executives charged, appeared on national television to brag about the safety of West End’s investments during the time that the fraud and concealment were taking place.

The SEC is seeking an injunction against future violations of securities laws for each of the defendants, as well as disgorgement and civil penalties. 

Legal News is part of our ongoing commitment to providing legal insight to our clients and colleagues. If you have any questions about or would like to discuss these topics further, please contact your Foley attorney or any of the following individuals:

Terry D. Nelson
Madison, Wisconsin

Peter D. Fetzer
Milwaukee, Wisconsin